AEI’s March 28, 2007 Subprime Seminar – XI
This is an unofficial transcript of another dozen minutes of the Q&A session from AEI’s March 28th seminar on the Subprime Mortgage Crisis. The present post completes Doom’s unofficial annotated transcript of the two hour long event. We will in due course be posting a Doom Page containing a complete unannotated version of the transcript, along with a brief summary post and overview of this important seminar.
The first questioner, Steve Votaw, appears to indeed be with Deloitte, while Fiesel Chor (spelling only approximate) self-identified as an independent consultant. Mr. Chor is the only participant we didn’t find at least something on by searching the internet, so if any Doom reader can point us to information about him or his consultancy it would be great.
Tom Zimmerman spoke to issues raised by both questioners, in the process shedding considerable light on the subprime sector, their methods and the motivations behind the present situation. Then Nouriel Roubini sort of banked off a concern of Chor’s to assert that we really, really need some sensible regulation in mortgage finance. Alex Pollock very briefly suggested this would not be enough to stop the next (inevitable?) cycle.
Previous partial transcripts of the March 28th event:
- I – [1:37:18-1:43:44] A Slightly Off-Beat Question, April 5, 2007
- II – [1:54:05-1:56:30] Subprime Spillover Discussion – and a Bit of Business, April 7, 2007
- III – [1:20:30-1:25:40] Securitization on Trial – Bert’s First Question, May 7, 2007
- IV – [0:22:36-0:36:11] Roubini at the American Enterprise Institute, May 16, 2007
- V – [0:50:56-1:16:21] Early Pay Defaults Drove the Subprime Crisis – Zimmerman Transcript, June 7, 2007
- VI – [0:00:00-0:06:21] A Good Start — Pollock & Bagehot Tee It Up, June 9, 2007
- VII – [0:06:25-0:22:36] Subprime To Dominate 2008 Election, June 14, 2007
- VIII – [0:36:29-0:50:55] Where’s the Risk? Whalen Presentation Curiously Timely, June 15, 2007
- IX – [1:16:27-1:20:30] A Vicious Circle of Housing Inventory, June 24, 2007
- X – [1:25:40-1:37:06] Recession – Already Baked In, July 2, 2007
As usual, the times are from the audio version of the seminar.
Alex Pollock [1:43:44]: … I think I had a question over here that’s been waiting patiently.
Steve Votaw: Hi, thanks. It’s Steve Votaw with Deloitte. I had a question about the … we talked about the consumer getting squeezed by lack of refinancing opportunities, but I think these 2/28 guys — correct me if I’m wrong … and tell me where I’m wrong, but … if they make 22 payments in a row, they’re no longer a subprime borrower, right? So they’re going to have even better refinance opportunities than in one of the graphs we saw. I guess … LTV aside, maybe that’s probably the rub, but maybe you guys can expound a little on that. [1:44:23]
Alex Pollock: Tom I think that was really your interpretation —
Tom Zimmerman: Yeah I know, that’s correct. If you … One of the reasons that the subprime industry exists is, as one executive from one of the major companies once told me a year or so ago — he said, "Tom, we’re a bridge lender, man. We’re not a long term business here, we’re a bridge lender." But the fallacy with that is that if you go back to the old days before FICO scores were prevelent in the subprime world, and they all had A,B,C,D kind of credits instead of FICO scores — this was back in the mid-90s, and roughly, at that point in time, I don’t know where it breaks now but at that point in time about 50 percent of the people were A’s and the rest of them were B’s, C’s, and D’s. And when Freddie and Fannie decided they wanted to get in the business, they went after the top A’s in this market. So five or six years ago Freddie and Fannie opened up their guidelines and took off some of that cream of the crop so to speak. [1:45:18]
So you have two types of people in subprime: those who missed a few payments and for whatever reason they kind of slipped into the subprime world, and they cure their credit in a year and they’re gone and back up to prime world. So prepayment speeds in subprime when we had fixed loans, when we don’t have them anymore, when we had fixed prepayment — when we had fixed loans, the prepayment speeds were like, five times … no three or four times what they were in the prime world. And that was because people would cure their credit, go up to a prime loan, they’re out of there with no problem. The other half of the people, our B’s C’s and D’s, and they are always in subprime world. They’re always going to be there, they aren’t going to get out — they think they are going to get out, they’re not going to get out. So, some will and some won’t. So I understand your point. Some of these people will be able to finance out, but I think there’s a bunch of them that probably will not be able to do that. [1:46:13]
Alex Pollock: Josh, you were waiting patiently. OK? All right? … Second turn’s not for a while. [laughs]
Fiesel(?) Chor(?): Thank you. My name is Fiesel Chor, I’m a consultant, private consultant. I have a question about 2/28 and subprime. When the private sector designed that product, probably the designer of the product probably might have forecast what had happened in a couple of years because in a sense after about a couple of years there will be a jump in the interest rate of 6 percent, and I wonder whether at around the time about ’04 or first Q of ’05 if people expect there is a liquidity stretch at around the time. And then to really pick up the valuation of the price of the property at the time. Such kinds of products might be needed unless such product coming into the market place. There will be a cyclical correction in the property valuation and price. I wonder whether the private sector perceived that because of when Tom presented his position already it was ’05 or ’04. And why at that time the private sector more responsibly, more consultation with the government. Did some much better responsible matter. [1:48:16]
And another matter. At the IT meltdown in around 2001, I think the real estate sector really in a sense helped the economy to smoothly get out of the trauma.
As mentioned here, about 5 million people lost there jobs. But the real estate sector created a lot of jobs. And from the real estate agent, also all this fund organization, financing job. And what will be the next sector which will help if this meltdown — just in what you have said, will be realized … in 4 or 5 years. [1:48:57]
Alex Pollock: OK, I think we have two questions there. One is — at the time the subprime loans were being made here what kind of expectations, particularly of property price expectations would have made it make sense — that would be question 1. And question 2 is — if we had a sequential bubble of the real estate following the tech, what is the next thing that might come along as property followed the dot com boom. Anybody want to take the first question in terms of lender expectations. [1:49:29]
Tom Zimmerman: Well I think that 2/28 product really — what’s happened in the mortgage market is we really have gone from either ARMs or fixed to hybrids or fixed. There are very few just pure ARMs out there anymore — either in the prime world or in the subprime world. One of the reasons — they used to have — in 94,5,&6, it was split 50 percent fixed and subprime. 50 percent were fixed rate loans — most of them were 20, 15 or 25 year fixed rate loans, or they were 6 month LIBOR loans which were — they weren’t hybrids, they were flat 6 month LIBOR rates. And the six month LIBOR loans prepaid really fast. And back to this credit curing, back to whatever, and to slow down — because then it was unprofitable because the loans paid down so fast, it was an unprofitable proposition — the industry went toward, to slow the speed down they went toward prepayment penalties and they went toward these hybrid loans which were fixed for two years, which would hopefully keep the person in the loan longer than if the thing started to adjust every six months right away. So it was sort of a defense mechanism to go into this 2/28 product. [1:50:51]
The other part of this story is that the capital markets love floating rate securities. They don’t like fixed rate. All of Europe loves floating rate securities. And if you put too many fixed rate loans into a securitization, with not enough ARMs, then all of a sudden it becomes hard to hedge out that basis risk. So because the capital markets only wanted floating rate securities, it sort of constrained to, like, 25 percent fixed rate loans could be originated, and the other were these 2/28s which they knew they were fixed for 2 years, but then they started to float, so they could create LIBOR floaters out of this product. So the capital markets wanted floaters, one way you create floaters is to have a 2/28 product out there. So it was much more driven by that than by anybody’s expectations about the housing market going up or down. [1:51:45]
Alex Pollock: Nouriel, the second question?
Nouriel Roubini: Yeah, which one is going to be the next bubble? I think the question has to be first, who creates the bubble in the first place? And I think that the current conventional wisdom I’m not only convinced, the usual argument is … was caused by the Fed — the Greenspan or maybe now the Bernanke put. Greenspan worried about the Russian exuberance, that did nothing about it and let it fester then when went bust they aggressively cut rates, so they created a housing bubble and now it’s going bust and they are going to try to find another one. [1:52:17]
I think that the lesson of the last 3 recessions, actually more than an issue of monetary policy, is that in each one of these case, in which there was a boom and a bust, real estate in the 80s and then the recession, and then the tech boom and then bust, and now this housing boom and bust, is not an issue of monetary policy. I think it’s a question of the free markets — we’ve said at the beginning … people become exuberant, irrational exuberant … there is mania, there is greed, there is lots of other stuff, and therefore these things happen. So the right response in each one of case is sensible rules and regulations for supervision of financial markets. [1:52:46]
What the Fed did, or the mistake in the 90s was not to tighten the Fed funds rate by another 100 basis points, when people expect 100 percent increase in your tech stocks, that’s not going to make any difference. But you have margin requirements on borrowing, a leverage rate, and the stock market. When you have in these here like subprime, instead of having an ideology, and I would say there was a systematic ideology in Washington from Federal to State, local regulators to say, "Let’s do nothing — this is a private thing, let’s get the GSEs out of it." and they did get the GSEs out of it, most of subprime for the last few years and the mess was not created by Congress, it’s not that this mess was created directly by the Fed, it was not that the mess was created by the GSEs, it was a mess created by the fact there was an ideology of saying — free market work without any regulation, we’ll let markets work. And we saw the mess that happened. So what we need is having sensible regulation of financial markets of mortgages and other things. Otherwise this thing’s going to happen again. And we’ll not have learned the lessons of the past.
Alex Pollock: It’s my own view that this thing’s going to happen no matter what we do. We have two minutes left, and we’re going to take one more question.
Dan Geary: Also, before we go to our last question, I just wanted to let everyone in the audience know that Mr. Zimmerman’s presentation along with all the materials in your packages are on the AEI website.
Alex Pollock: Thank-you Dan. … [1:54:04]
Notes and References: "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble", Event, American Enterprise Institute & Professional Risk Managers’ International Association, March 28, 2007.